[This article was first published for our Inside the Income Factory® members and trial subscribers on June 22nd.
“Discounts on Discounts” Explained
Every shopper loves discounts, and investors are no different. But several of our Inside the Income Factory members have asked me for more details on the discounts, and especially the “discounts on discounts,” that we often achieve when we buy some of our favorite asset classes via closed-end funds.
A great current example is the senior loan sector, where we buy senior, secured corporate loans through closed-end funds managed by some of the top credit shops in the country, like Ares, Apollo, Blackstone, Invesco, Eaton Vance, etc.
Let’s take two of the funds we hold – Apollo Senior Floating Rate Fund (NYSE:AFT) and Blackstone Long/Short Credit Fund (NYSE:BGX) – as examples of how “discounts on discounts” can increase our yield without increasing our risk.
Discount #1: Discount on the Fund Itself
Both of these closed-end funds focus primarily on senior corporate loans, with a smattering of other corporate debt in their portfolios as well. What makes the two funds particularly attractive right now is that we can buy them each at a discount from their fund’s net asset value of over 14% (the discount is -14.7% for AFT and -14.1% for BGX).
If you add up the current market value of all the loans, bonds and other assets that a fund owns, and then divide by the number of outstanding shares of the fund, you get the net asset value (“NAV”) per share. This is true of ALL funds, whether traditional open-end funds, or closed-end funds. The NAV is what each share would be worth today if you dissolved the fund and divided up all the holdings among the shareholders. With a discount of more than 14%, it means the market price we currently pay to buy either fund’s shares is just a shade below 86% of that share’s NAV.
Obviously a 14% discount is a good deal. In the case of AFT and BGX, the distributions they pay to shareholders represent a yield of about 9.6% on the funds’ NAVs. In other words, an investor who paid full price for the funds (i.e. paid the actual NAV per share, as you would if they were traditional open-end mutual funds) would earn a yield of 9.6% on their investment. But with a 14% price discount, that same distribution payment now will represent a much higher yield to us (about 11.2%), since we only have to invest about 86 cents on the dollar to make the same investment and have the same amount of capital working for us. Check out the math: The funds pay 9.6 cents on the dollar, as a percent of their NAV. That 9.6 cents, divided by the 86 cents we pay as a result of our discount, equals 11.2%. (Math 101, smaller denominator, higher percentage.)
This is an important advantage, and is a good example of what I have called the “alchemy of closed-end funds” in describing how CEFs can take a given yield and often turn it into a higher one, with no increase in risk.
But It Gets Even Better, As the Denominator Gets Even Smaller
When a fund calculates its Net Asset Value, it uses the actual market value of its assets (i.e. what they are currently worth at today’s market prices). For less liquid assets, like many loans, high yield bonds, private placements, and other thinly traded securities, there is an element of estimation in determining a “mark-to-market,” but whatever estimates, algorithms, models, etc. are used, the goal is to determine what the assets would currently be worth if they had to be liquidated.
For large senior secured corporate loans of the type held by AFT and BGX, there is an active secondary market, so loan “mark-to-market” prices are fairly easily determined. Currently loans and other corporate debt asset classes are selling at discounts because of the credit market’s concerns about possible recession or economic downturn. This “worry discount,” as some have called it, is currently about 6%, with the S&P/LSTA Loan Index showing a market price average of about 94 cents. It was even lower at the end of May, when Eagle Point Income (EIC) reported in its monthly report that the average market price of the 1,432 corporate loans in the CLOs whose obligations EIC owned was 92.5 cents. So we can be pretty sure that the corporate loans AFT and BGX own are marked down by 6% or so, when those funds report their Net Asset Values.
What does this mean? Well, number one, the assets in funds like AFT and BGX (as well as other closed-end funds that own senior corporate loans) are marked down by 6% or so below their par values, when calculating the funds’ NAVs. But the funds would only incur that 6% loss if they went out and sold the loans in the secondary market, which they have no reason to do. In fact, the funds, just like any other lender, can collect their loan repayments from the borrower at 100 cents on the dollar when they hold them to their stated maturity, which of course is what most lenders and loan investors do.
That means every time a fund collects the 100% par value repayment at maturity of each of its loans that it previously carried at 94% in computing its Net Asset Value, it notches a 6% capital gain on its NAV. So corporate loan funds are essentially carrying a more or less “hidden” 6% capital gain for investors, even if we had to buy them at the full amount of their Net Asset Values.
But as we saw above, we aren’t buying the funds for their full NAVs. We are getting a 14% discount off the NAV. That’s a 14% discount off a portfolio of loans whose prices have already been marked down by about 6%. This compounding of discounts, like “double coupons” at the store, can be summarized like this:
- Our discount on the fund itself means we’re paying about 85% of the fund NAV, which itself only values the loans at about 94% of their par value, which is the actual value when held to maturity.
- So we end up paying: 85% X 94% = 80% of the par value of the underlying loans.
- In other words, an overall 20% discount.
Downside Compensation
You may ask: Is a 20% discount enough margin to cover a possible recession or downturn?
Many economists and forecasters are projecting default rates could reach as high as 4-5% per annum in a recession, so if the recession lasted as long as two years we could actually have cumulative defaults of 9-10%. With senior loans, the average recovery of principal, in the event of default, has historically been between 60-75%. So assuming 60% recoveries (i.e. 40% losses), at the high end of 10% total defaults, you’d have portfolio losses of perhaps 40% times 10% = 4%, spread over two years. That’s 2% per annum for two years on a portfolio on which I’m earning a yield of over 10% per annum. And many economists are predicting that whatever downturn or recession we get may not even be that serious. That’s a downside I can live with, and probably a lot milder than the downside I would face in equities if the same economic scenario were to occur.
While there is no way to prove this, my feeling is that the current discounts on both the loan assets themselves (i.e. the 6% discount built into the fund’s own NAVs) and on the funds’ market prices themselves (i.e. a 14% haircut), when considered together (i.e. a 20% overall discount), are overcompensating us for the risks that may lie ahead.
Obviously there is plenty of uncertainty to go around. But I can live with this sort of uncertainty if I’m collecting the 11% and higher distribution yields that our senior loan funds and other credit funds are currently paying us.
Thanks for all your interest and support.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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